Credibility: a security the Fed cannot purchase

In a speech today, Federal Reserve Chairman Ben Bernanke addressed concerns that the Federal Reserve's recent expansion could cause inflation down the road.

As a general rule, my strong preference is that any firm that cannot meet its obligations should bear the consequences of the marketplace. But recent circumstances have been truly extraordinary.

Bernanke went on to discuss the "waves of panic and fear" that impacted markets and lead to action by Treasury.

Yet these extreme cases are the ones that make providing credible threats not to intervene in the future difficult. It's easy to not intervene when only one institution is set to fail (see Lehman Brothers) but it's the systemically risky cases (see AIG one day later), where the Fed and other government agencies have the hardest time keeping their hands-off policy. This difficulty has been part of why Bernanke has asked Congress for more rules lately. While not looking to eliminate the freedom under Section 13 (3), rules from Congress could act as a backstop to the Fed's credibility.

A great post by Mark Thoma over at Economist's View, provides a great primer on Fed credibility, plus a few helpful charts.